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Evidence-Based Investment Insights: Part III

 
   

   

The Human Factor: You and Your Portfolio

In our last installment of Financial Insights, we described the relationship between market risks and expected reward, and other factors involved in evidence-based portfolio construction. We turn now to the final and possibly the most significant factor in your evidence-based investment strategy: the human factor. In short, your own impulsive reactions to market events can easily trump any other market challenges you face.

Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated, "survival of the fittest" instincts and emotions that spur us to leap before we have time to look.

To study the relationships between our heads and our financial health, there is another field of evidence-based inquiry known as behavioral finance. Wall Street Journal columnist Jason Zweig’s "Your Money and Your Brain" provides a good guided tour of the findings, describing both the behaviors themselves as well as what is happening inside our heads to generate them. To name a couple of the most obvious examples:

When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to "Sell!"

When markets unexpectedly soar – Your brain’s reflexive nucleus accumbens fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to seize the day. "Buy!"

Beyond such market-timing instincts that lead you astray, your brain cooks up plenty of other insidious biases to overly influence your investment activities.

Rapid reflexes often serve us well in everyday living. But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by instinct-driven, chemical reactions. To name a few, here are a half-dozen of the more potent behavioral biases, and how you can avoid sabotaging your own best-laid investment plans by recognizing the signs of a behavioral booby trap.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens when you see a market movement afoot and you conclude that you had best join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a run on a stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a country in economic turmoil. Either way, following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.

Behavioral Bias #2: Recency

Even without a herd to speed your way, your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. Stocks have historically delivered premium returns over bonds, but whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek "safe harbor" (or vice-versa when bull markets on a tear).

Behavioral Bias #3: Confirmation Bias

Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news shows that support our belief structure; we’ll skip over those that would require us to radically change our views if we are proven wrong. This is one reason why a rigorous, peer-reviewed approach becomes so critical to objective decision-making. Without it, our minds want us to be right so badly, that they will rig the game for us, but against our best interests as investors.

Behavioral Bias #4: Overconfidence

Garrison Keillor made overconfidence famous in his monologue about Lake Wobegon, "where all the women are strong, all the men are good looking, and all the children are above average." Keillor’s gentle jab actually reflects reams of data indicating that most people (especially men) believe that their acumen is above average. On a homespun radio show, impossible overconfidence is quaint. In investing, it’s dangerous. It tricks us into losing sight of the fact that investors cannot expect to consistently outsmart the collective wisdom of the market, especially after the costs involved.

Behavioral Bias #5: Loss Aversion

As a flip side to overconfidence, we also are endowed with an over-sized dose of loss aversion, which means we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. One way that loss aversion plays out is when investors prefer to sit in cash or bonds during uncertain markets. Even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns to be had by remaining invested according to plan.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we tell ourselves we don’t want to sell until it’s at least back to what we paid. In a data-driven strategy (and life in general), the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of past holdings that no longer suit your portfolio’s purposes, an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.


Series Summary

We hope you’ve enjoyed reading our three-part evidence-based investment series this year as much as we’ve enjoyed sharing it with you. When we introduced our three essential ideas for building wise wealth, we sought to replace most of the technical jargon, with three key insights for becoming a more confident investor:

  1. Understand the Evidence. You don’t have to have an advanced degree in financial economics to invest wisely. You need only know and heed the insights available from those who do have advanced degrees in financial economics. 

  2. Embracing Market Efficiencies. You don’t have to be smarter, faster or luckier than the rest of the market. You need only structure your portfolio to play with rather than against the market and its expected returns.

  3. Managing Your Behavioral Miscues. You don’t have to – and won’t be able to – eliminate every high and low emotion you experience as an investor. You need only be aware of how often your instincts will tempt you off-course, and manage your actions accordingly. (Hint: A professional advisor can add huge value here.)

     

How have we done in our goal to inform you, without overwhelming you? If we’ve succeeded in bringing our evidence-based investment ideas home for you, we would love to have the opportunity to continue the conversation with you in person. Give us a call today.

 



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